Regardless of which blockchain you choose to use for DeFi, you must remember that every transaction can have tax consequences. Investors must be cognizant of the tax implications as the IRS is actively working to scale its enforcement on centralized exchanges and DeFi. Ignoring your DeFi transactions when it comes to tax reporting could severely handicap your investment strategy.
 

We covered the main principles of crypto taxation in our blog post from last week. These same basic principles apply not just to Bitcoin but also to Ethereum, Solana, and every other cryptocurrency. There are other intricacies we must consider when dealing with cryptos, such as Ethereum and Solana.

Taxes on Buying Ethereum or Solana

Just like with Bitcoin, purchasing Ethereum or Solana with fiat is not taxable. However, many crypto investors tend to purchase these coins by exchanging another coin. A typical path we see many newcomers take is first purchasing Bitcoin with fiat, only to later exchange some of this Bitcoin for another coin. Remember, buying with fiat is not taxable, but if you use another cryptocurrency to purchase (trade) your Ethereum, Solana, or any other coin, you will have a taxable transaction from the disposition of the coin you are giving up on the exchange. This remains true even if you buy Bitcoin with another crypto.

So remember, purchases of any crypto with cash are nontaxable, but taking crypto to convert, trade, swap, or exchange into another crypto will always be a taxable disposal of the crypto you give up.

Taxes on Swapping, Trading, or Using Ethereum or Solana

As we already alluded to, any time you choose to sell, exchange, or use Ethereum, Solana, or any other crypto as a form of payment, you will have a taxable disposal that you must report, whether that disposal leads to a gain or loss. It doesn’t matter what coin you give up and what coin (goods or services) you receive - if you are giving up a cryptocurrency, you will have a taxable transaction. This remains true even when you trade USDT or USDC - while these are considered stablecoins, the tax treatment is the same as that of any other cryptocurrency. 

Your gain or loss is calculated based on:

Taxable Gain (or Loss) = Proceeds - Cost Basis 

 Proceeds = Amount in USD you received for your crypto. If you exchanged your crypto for another asset or used it to pay for a good or service, this is the asset's fair market value at the time of the trade.

 Cost Basis = Cost to acquire your crypto, including any acquisition fees.

A good rule of thumb is that if a cryptocurrency leaves your possession, there is most likely a taxable event to report; transfers to other exchanges or wallets you control are not included, as these are essentially nontaxable transfers to yourself. To illustrate this, let’s go over the most common ways of disposing your crypto assets:

Taxes on Staking Rewards

As we previously covered, one key similarity between Ethereum and Solana is the ability to stake both cryptocurrencies to earn staking rewards on your existing crypto, generally ranging from 4% to 8% APY. Just like the interest you earn on your deposits at a bank is taxable, so are staking rewards.

A key question here is how such staking rewards are taxed. The consensus, which the IRS has confirmed through Rev. Rul. 2023-14, is that any staking rewards you receive are taxed as ordinary income based on the fair market value of the coins at the time that you receive them. Given this treatment, it would be reasonable for taxpayers to save a percentage of each staking reward received to pay for the tax on this; this should be converted into USD and saved as such to mitigate the risk of price decreases, which could be detrimental to your ability to pay the tax on staking income. Remember, even a stablecoin can collapse, so keeping your tax funds in USD is always safer.

Another school of thought believes that staking rewards should not be taxed upon receipt but when you sell, trade, or swap such coins. This is a very reasonable argument given that these rewards are obtained as property, not cash, making withholding for taxes extremely difficult. Furthermore, a key question remains: does a taxpayer have accession to wealth when receiving staking rewards, or is this kin to having one slice of pizza cut into smaller portions as the current coins are diluted due to the staking rewards? This is currently being challenged by the Jarretts in the US Courts, and while the IRS has not commented, the Jarretts continue to pursue litigation to get a final answer.

Taxes on Other DeFi Activities

One of the biggest pitfalls for Ethereum and Solana investors is for those who take the leap into the DeFi ecosystems of these chains. With hundreds of apps, users can swap, stake, bridge, lend, borrow, provide liquidity, and do many other transactions using the Ethereum or Solana blockchains without relying on a centralized exchange. This means that no institution will keep track of your tax records. Does this mean that you don’t have to report DeFi taxes? No.

While the Treasury and IRS proposed regulations aim to have decentralized apps do some sort of reporting, industry experts agree that due to the decentralized nature, this will be a challenge. Regardless, we must keep in mind that our tax system is based on self-reporting; as such, it is the taxpayer’s responsibility to track, calculate, and report any taxes due. Keeping track of the data on DeFi can be challenging, even though this data is on the blockchain, and high transaction volume and multiple wallets can complicate this task. For this reason, we recommend using crypto tax software or relying on professionals to calculate your gains. Even with the best tools, a professional crypto accountant can help you report the correct amounts, eliminating the risk of overpaying your taxes if you try to calculate this yourself. At CryptoTaxAudit, we have helped hundreds of high-volume DeFi traders correctly report their gains; if you need help, schedule a consultation today.

Beyond complexities due to high volume, other complexities from DeFi arise due to certain types of transactions, as blockchain developers keep getting more clever and coming up with sophisticated transactions that we have never seen before in the traditional finance world. Some examples of transactions for which you may not find IRS guidance are:

• Liquidity Pools: The conservative approach is to treat providing liquidity on a DEX as a taxable exchange, after all, you give up your current coins and receive LP tokens in exchange. However, another school of thought suggests these should be treated as deposits. To further complicate matters, LP token rewards are difficult to track for most software, as tokens continuously accrue. In addition, different DEXs operate differently; for example, Uniswap V3 gives liquidity providers an NFT upon opening a position. However, this NFT is kept even if you remove all liquidity, raising further questions as to the correct tax treatment.
• Staking: We have already covered the different opinions on the taxation of staking rewards; however, tracking this data when done on DeFi can become even more difficult. Furthermore, liquid staking has been getting traction lately, in which taxpayers essentially swap their tokens for other tokens, raising the question of whether these should be taxable exchanges.
• Airdrops: Anyone who has actively traded on a DEX or holds multiple tokens has seen new tokens magically appear in their wallet. These airdrops are taxed as ordinary income at the time that the taxpayer obtains possession of the coins. But how many are scam tokens? What should their valuation be? What if you didn’t want the airdrop? All key questions that complicate reporting airdrops.
• GAS Fees: While this may be a moot point for Solana users due to their fees being less than a pretty penny, Ethereum users are familiar with paying hundreds or thousands of dollars in GAS fees. Are such fees deductible? What if they are not part of the costs to acquire a coin but rather transfer fees or other smart contract fees that did not lead to acquiring a new asset?
• Bridging and Blockchain Data: Users can now easily bridge assets between different blockchains thanks to many dApps that allow users to do just this, go from Ethereum to Solana or any other DeFi ecosystem. The challenge here is if the asset changes in name even though it represents the same asset, is this a taxable event? Furthermore, will your crypto tax software tool of choice be able to correctly import the data from such bridges? What if you are using a newer blockchain with less than 10,000 daily active users; will this even be supported?

All of the above reasons make reporting DeFi taxes extremely difficult. And for that reason, it could be very easy for taxpayers to misreport their transactions. Our team has a lot of experience with every type of DeFi investor, so do not hesitate to reach out if you are active in DeFi.

Conclusion

Ethereum and Solana are two of the world's most promising crypto assets, being the dominant smart contract platforms today. With over 2 million daily active users combined, these blockchains are poised to see massive growth over the next few years if mainstream adoption of their DeFi ecosystem materializes. Whether you chose the time-tested Ethereum or the faster, cheaper, and newer Solana, you must be cognizant that you are creating taxable transactions every time you use their ecosystems.

Due to the volume, data, and lack of guidance, we encourage you to reach out and work with our seasoned crypto team to calculate your taxes. While it is possible to calculate on your own, the many complexities could result in you overpaying your taxes if you are not savvy with the many intricacies of tax reporting. Do not pay more than you legally should because you have poor data. Let our team help you so you can return to finding the next 1000X gem on Ethereum or Solana.

If you are a cryptocurrency investor, it is important to comply with tax regulations to avoid any legal or financial troubles. CryptoTaxAudit.com is a specialized service provider that can assist you in complying with cryptocurrency tax laws. We offer personalized solutions to cater to the unique needs of individual crypto investors. If you want to ensure that your cryptocurrency investments are tax-compliant, do not hesitate to contact CryptoTaxAudit.com today!